The imminent arrival of the EU-wide AIFM Directive is set to shake up the apple cart somewhat, in terms of how hedge fund managers approach internal governance. Many London-based managers are, of course, perfectly comfortable with their compliance obligations under the FCA (formerly FSA).

And whilst the Directive, on face value, should not require managers to make wholesale changes internally, it will present a more nuanced challenge. In effect, AIF managers will need to approach the way they run their AIFMD-compliant firms almost as if they were UCITS managers because this is the filter through which the FCA will likely view managers according to Michelle Carroll (pictured), partner in the investment management division at BDO.

“Managers have to adopt a mindset as if they were running a UCITS-compliant fund. They need strong governance over policies and procedures, and documentation, which would be the equivalent to what you would find if running a UCITS fund,” suggests Carroll.

The compliance that UK-regulated managers have learnt to live with is kind of the old way of doing things. “Now they need to actually think about what is their conflicts of interest policy, does it need to be updated? Have they evidenced that they’ve updated such a policy? Expectations have risen with AIFMD and managers need to be aware of that.”

In many respects, the EU Parliament intends the spirit of the UCITS framework to be closely mirrored in the Directive as it applies to alternative investment funds. They are, as it were, two sides of the same regulatory coin. As said, managers who choose to become AIFMD-compliant are not going to face massive internal upheaval. The key difference to what they were doing previously, and what they will be expected to do going forward, will, says Carroll, be in the evidencing and documentation of the underlying policies and procedures:

“I think the nuance lies in the mindset that needs to be adopted with regards to documentation and evidencing. Most hedge fund managers have failed to fully appreciate that yet.

“I think there is a slight risk that those hedge fund managers who are already regulated won’t think that there’s a huge requirement to change under AIFMD. On face value, that’s probably right, but I think there’s a slight change in expectations, particularly at the EU level, that you’re actually going to look more like a UCITS manager,” explains Carroll.

This is not to suggest that managers are overnight going to start marketing their hedge funds to retail investors. Rather, it is to encourage them to think from the market regulator’s perspective. Carroll does not believe that the FCA is going to start hunting down AIF managers. They will likely be pragmatic, but there are key points in the FCA’s policy stance that managers should be mindful of, going forward.

“The key thing I would stress test is that policies and procedures and governance around trading clearly tie back to the fund’s investment objectives. Under the Directive, and the FCA’s rules, there needs to be a link between the investment objectives and investors coming into the fund who expect to be duly rewarded. That’s the whole point of collective investment schemes: for investors to pool together and to get returns from a specific investment objective.”

Any deviation away from this, which has not been evidenced or written in to a firm’s investment documentation, will potentially open up Pandora’s Box, especially if a fund is unfortunate to suffer a blow up. In such a scenario, the AIF manager should ensure that they’ve got their house in order.

“What I would be looking at if I were the FCA is whether the trading activity of the fund truly reconciles back to the investment objectives because that would be the hook for the FCA to say ‘Hang on, you’re not acting in your investors’ best interests’. Although I don’t think the FCA will clamp down on managers per se, were something to go wrong with a fund, however, these policies and procedures for a fund’s trading strategy would be the first thing they would target,” adds Carroll.

While Carroll is perhaps taking a worst-case scenario here, it is far better for managers to err on the side of caution than potentially get stuck on the wrong end of a regulatory investigation; the reputational risk alone could be catastrophic.

“You might not think that your operations need to be UCITS-equivalent in terms of protecting investors but if there is a problem in the fund, and the FCA pays you a visit, that’s exactly the mindset they will be bringing,” emphasises Carroll.

Continuing the UCITS theme, another area for managers to think about is the use of soft limits in their trading software. Previously, if the system told the hedge fund trader that adding another X per cent of risk exposure to a certain stock would breach, for example, a 10 per cent soft limit, they would acknowledge it but continue with the trade.

“Now, if the fund failed, the FCA would immediately raise the point that the manager had chosen to ignore the warning on the trading screen. What did they do in Compliance to ensure that that was appropriate to ignore? Where did they document that they understood the investment objectives and were comfortable with these investment limits while choosing to ignore the soft limits?

“By moving closer to the UCITS world under the AIFMD, hedge fund managers will have to think carefully as to whether they have documented why they have set a particular soft limit and under what circumstances a trader can ignore that soft limit. Can they provide evidence of training around soft limits? Can they show evidence of compliance monitoring when limits are breached? There is going to be much more evidencing needed under the AIFMD.”

With respect to marketing, the FCA’s last policy statement made it clear in that if an investor provides written confirmation that they approached the manager, it constitutes passive marketing.

The next sentence says…’but we will look for evidence of marketing nonetheless’. What this demonstrates is that managers should beware of attempting to rely on written declarations from investors to deliberately bypass becoming AIFMD-compliant. That alone will not keep them out of hot water if it is proven that the manager was actually actively marketing and approaching investors, rather than the other way round.

Of course, the simple way to avoid this is to become fully compliant, benefit from passporting, and actively market the fund across the EU. But deciding whether to leverage on the success of the well-established UCITS brand will depend on each individual AIFM. Given the costs involved, it is something that managers will need to carefully weigh up.

“As a fund manager you’ve got to question whether there are positive brand opportunities to start with. If yes, and there is potential for good brand recognition among investors in the AIFMD, as a fund manager you’re probably going to want to go out and market your fund product(s) and say ‘Look at me, I’m AIFMD-compliant’.

“I would advise managers to obtain external assurance from a firm like BDO to confirm that they are indeed AIFMD-compliant. Managers need to ramp up their existing governance structure, and if they need to take external advice on how to do that, that’s where BDO can help.

“Our clear recommendation is to ensure that everything is evidenced and documented from the governance aspect at the top all the way down to KYCs on investors, due diligence on third parties, reviewing data provided by depositaries on transactions and trades. It’s about having evidence at all levels within the AIFMD-compliant firm.”